Depreciation

Understanding accounts series

Introduction

Depreciation is something of a nightmare because first of all business owners and directors – not the accountant – are supposed to decide on how much depreciation should be included in the accounts. The facts of the situation are that most often it is the accountant who makes those decisions and the business owner or director just nods and agrees with what the accountant has already decided.

So what is depreciation?

At its simplest, it represents the wear and tear that most business assets experience through usage. A computer doesn't usually stop working after three years but it usually needs replaced or upgraded as newer IT applications need even bigger RAM and a faster processor to let them work successfully.
Of course, depending on the age of the computer, it may not be possible to upgrade the RAM and so you need to buy a new one. Office furniture never seems to wear out, does it? In one business we worked in recently the equipment it used on the factory floor had been around for about 40 years and was still going strong.
How do you decide on the rate of depreciation (or how long it will take for the asset to completely wear out) in these cases? You can see why accountants get the job of measuring depreciation!
At its most complex, depreciation is a way of ensuring that the value of the assets in the accounts reflects its remaining useful economic life.
There are two methods in general use that are used for calculating the costs of depreciation. Each of these can be modified by incorporating a residual value.
The straight-line method
You decide on what rate (%) of depreciation is relevant and apply this rate to the initial cost or book value until the net book value is zero.

Computer costing

£900

Depreciation rate 33.33%

£(300) Year 1

Net Book Value

£600

Depreciation rate 33.33%

£(300) Year 2

Net Book Value

£300

Depreciation rate 33.33%

£(300) Year 3

Net Book Value

£0

The other main method is the reducing balance method, which applies the depreciation rate to the net book value at the end of the year:

Computer costing

£900

Depreciation rate 33.33%

£300

£600

Depreciation rate 33.33%

£200

£400

Depreciation rate 33.33%

£133

£267

Depreciation rate 33.33%

£89

£178

Depreciation rate 33.33%

£59

£119

So you can see that with this method it takes much longer to write the asset down to zero. In fact, it takes 17 years to get the net book value down to under £1!
There is a place for each of the methods, but the second method – because it takes so long to write the asset down to zero – is best used in particular circumstances and so needs to be chosen and used with care.

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic.
No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers.
Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant.
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